Building the institution of Insolvency Practitioners in India

by Anirudh Burman.

Professions

Some of the time, individuals directly consume goods or services without the requirement of an intermediary. For example, if one wanted to buy a telephone connection, one does not need expert advice on how to buy one, or which telephone connection to buy, and so on. In some other sectors however, there is a need for intermediation. For example, getting treatment for an ailment or a disease requires the expertise of a doctor who stands between the patient and treatments. Similarly, entering into legal transactions and resolving legal disputes requires the expertise of lawyers.

Generally, the need for specialised intermediation increases with the sophistication of a transaction and how critical it is in one's life. Such specialised intermediation gives rise to professions which provide these complex and critical services, such as chartered accountants, doctors, and lawyers.

The need for regulation of professions

Market failures can arise in transactions between customers and professionals owing to asymmetric information. Customers of specialised services are often not able to judge the knowledge of a professional and are not able to judge whether services that were promised and paid for were actually delivered. For example, in many cases, a person discovers much later that their doctor or lawyer gave them the wrong advice, or did not exercise adequate dilligence in their case. Under these circumstances, if the law mandates that certain services must be purchased from a professional, this merely creates rents for professionals.

The need to protect consumers then justifies government regulation of such professions. By setting minimum standards and entry requirements, and enforcing penalties against violations, the State can improve outcomes where consumers cannot easily understand ex ante, the quality of a product. This is particularly important where specialised knowledge or skill is involved. As a consequence, we now have many regulated professions in India.

The approach taken by the Indian legislature has, however, turned out to be inadequate. Our regulatory approach has generally been to recognise that such professions are special, and to grant recognition to one national self-regulatory body to set and enforce standards of conduct for all professionals in that sector.

For example, the Bar Council of India is a legally recognised self regulatory organisation that is the only national body setting and enforcing codes of conduct against lawyers. The Medical Council of India is a legally recognised SRO for doctors in India. Both these bodies, among other legally recognised SROs, are widely viewed as having failed in enforcing standards that are of benefit to consumers. There are few, if any disciplinary actions against errant lawyers and doctors that the BCI or MCI take. There is no regular examination or evaluation of professional skills. There is, hence, a need for fresh thinking in how professions should be regulated.

The failures of the existing arrangements is grounded in the weak institutional structure and legal framework surrounding self regulatory organisations. The existing SROs have badly defined incentives to protect consumers. Their incentives are instead, designed towards protecting their members.

A new approach to regulating professions

A new approach towards thinking about SROs is required (Shah, Rajagopal, Roy, 2013). This requires thinking of SROs as mini-states rather than clubs. A state exercises legislative (standard setting), executive (conducting exams, skill building, and investigating complaints), and judicial (imposing penalties) powers. An SRO must be designed so as to function as a mini-state rather than an insulated priesthood accountable to none.

One feature of regulatory design that can improve the working of SROs is competition. A competitive market of SROs would be one where multiple SROs in a sector compete to corner a greater share of consumers on behalf of its members. The relevance of a SRO would then depend on its reputation, and therefore the reputation of its member professionals. The UK for example, has multiple SROs for insolvency professionals, differentiated by the quality of their codes of conduct, their entry barriers, and consequently the quality of their members. The government objective of consumer protection is therefore enhanced by promoting a competitive field of SROs as opposed to the current system where SROs are legally recognised monopolies.

At the same time, if SROs become for profit entities, then there can be tension between the objective of business development for the shareholders as opposed to the regulatory function. In some situations, e.g. exchanges, where there are network effects, this can work fairly badly. The ownership and governance of SROs needs to be regulated to help ensure they are well incentivised to pursue the regulatory functions.

Version 1.1 of the draft Indian Financial Code has a treatment of these issues in the context of the laws governing Financial Market Infrastructure Institutions (FMII) which are mini-states with legislative, executive and quasi-judicial functions. The experiences in India of setting up exchanges, and dealing with the two extremes of an exchange which did not enforce against its own and an exchange which sacrificed regulatory functions in the quest for profits, have given considerable clarity on how to think about for-profit exchanges which are SROs that are mini-states.

SROs of insolvency professionals

In a recent paper (Burman and Roy, 2015), Shubho Roy and I propose design principles for a new regulated profession in India: insolvency professionals. This was part of the research that fed into the Indian bankruptcy reforms.


A good insolvency framework is beneficial for society as it allows for the efficient reorganisation of capital, and creates dynamism in the market. Additionally it enables sick firms and individuals to have a fresh start. Insolvency professionals provide sophisticated services to customers undergoing insolvency, or requiring assistance with regard to insolvency proceedings. Their intermediation is essential for ensuring good outcomes in an insolvency process. Insolvency professionals generally perform the following critical functions in the bankruptcy process:

1. Nominee or supervisor of a voluntary arrangement.
   
2. Interim Receiver.
   
3. Trustee in Bankruptcy.
   
4. Trustee under a Deed of Arrangement.
   
5. Trustee of a Trust Deed for Creditors.
   
6. Trustee of the insolvent Estate of a deceased individual.
   
7. Administrator.
   
8. Administrative receiver.
   
9. Liquidator.
   

Insolvency practitioners need to be regulated because the lack of trust in their services would lead to an erosion of trust of the insolvency process. Secondly, in a bankruptcy process, insolvency practitioners act as agents of the state.

However, direct regulation of insolvency professionals by the government is not feasible in the long run. Like all sophisticated services, this profession will also devise its own norms and codes of conduct that are suited to changing needs of consumers. State intervention can actually retard, if not inhibit this process. Therefore, the creation of SROs of insolvency professionals is essential for the success of an insolvency and bankruptcy regime. This however does not mean that SROs be created with vague objectives and low accountability. Government regulation of SROs can play an important role in shaping the incentives of SROs and their members in order to produce the best possible outcome for consumers.

Government regulation of insolvency professionals must therefore do the following:

1. Recognise and regulate SROs of insolvency professionals.
   
2. Ensure that consumer protection be a key objective of insolvency professionals, that SROs must ensure.
   
3. Ensure that SROs clearly define their internal legislative, executive and judicial powers in the best interests of consumers.
   
4. Create well defined offences and penalties for errant insolvency professionals.
   
5. Ensure a competitive market for SROs.
   
6. Leave leeway for SROs of insolvency professionals to compete on parameters such as quality of members, entry requirements, codes of conduct and quality of grievance redress.

The Draft Insolvency and Bankruptcy Code

The Finance Ministry has published the report of the Bankruptcy Law Reforms Commission, which includes a draft law which is a unified framework for insolvency and bankruptcy processes for firms and individuals. It also proposes the creation of insolvency professionals and enables the licensing of multiple SROs of insolvency professionals. The Government has introduced a bill in Parliament, the "Insolvency and Bankruptcy Code, 2015", building on the draft law proposed by the BLRC. This step is welcome. However, some improvements to the proposed framework are essential in order to enable the profession to serve its purpose.

The Bill creates a regulator that will regulate insolvency professionals and IP SROs. The Bill does not mandate minimum governance structures for IP SROs. For example, it does not mandate the separation of legislative, executive and judicial powers. Critically, it does not place any emphasis on the independence and efficacy of the judicial function of disciplining IPs who are members of IP SROs. If consumer trust in IPs is to be developed and maintained, IP SROs have to be mandated to ensure that disciplinary actions against errant members are conducted impartially and efficaciously. Existing professions regulated by SROs face cynicism precisely because of the poor standards of enforcing discipline within the SRO.

An efficient insolvency and bankruptcy regime requires a cadre of insolvency professionals. Their services are both complex, and critical for the economy. The law must be clear in the regulatory objectives behind their regulation, and set certain minimum standards of performance for both IPs and IP SROs.

References

Anirudh Burman, Shubho Roy. Building the institution of Insolvency Practitioners in India, Working Paper, 2015.

Ajay Shah, Arjun Rajagopal, Shubho Roy. From clubs to States: The future of self-regulating organisations, Ajay Shah's blog, December 19, 2013.


Anirudh Burman is a researcher at the National Institute for Public Finance Policy.